Dilution Posts

We get this question all the time and there’s no right answer. So I started a discussion on Quora to learn more. Here’s my answer:

Raise less if you want to keep your valuation down and keep the option open for an early exit where everyone (investors, employees and founders) makes money.

Raise more if you’re here for the long term and you want to protect your company from poor funding environments or hiccups in your growth. Just try to maintain control, monitor your liquidation preference, and monitor your dilution. Also understand that, if your valuation is high in this round, you will have to make a lot of progress for the next round to be an up round.

In summary, raise too little money and you may go out of business when you run into trouble. Raise too much money and you may make less dough when you exit. Take your pick: disaster vs. dilution.

In either case, try to act like you don’t have a lot of money. The conventional wisdom is that when you have a lot of money, it’s hard not to slow down because you start spending it (which takes time in and of itself) and you start thinking that you have a lot of time left before you die, so what’s the hurry?

Read the rest of my answer on Quora. Also see this old post on Venture Hacks for related quotes from Eugene Kleiner, Bill Janeway, and Marc Andreeessen.

“… You should try to answer the question: what is the biggest risk your startup is facing in the upcoming year and how can you eliminate that risk? You should come up with your own answer but you should also talk to lots of smart people to get their take (yet another reason not to keep your idea secret).

“For consumer internet companies, eliminating the biggest risk almost always means getting ‘traction’ — user growth, engagement, etc. Traction is also what you want if you are targeting SMBs (small/medium businesses). For online advertising companies you probably want revenues. If you are selling to enterprises you probably want to have a handful of credible beta customers.

“The biggest mistake founders make is thinking that building a product by itself will be perceived as an accretive milestone [emphasis added]. Building a product is only accretive in cases where there is significant technical risk — e.g. you are building a new search engine or semiconductor.”

If I had to stuff my answer to this question into one sentence, I would say: “As much as possible while keeping your dilution under 20%, preferably under 15%, and, even better, under 10%.” Raising as much as possible is especially wise for founders who aren’t experienced at developing and executing operating plans.

“My question is how do we value a company with no sales? I understand it’s an arbitrary valuation but is there anything we can possibly base it on? Is there a “default” valuation for companies in a seed round?”

We’ll answer this question with some questions (and answers) of our own:

1. How much money do we need?

First, figure out how much money you need to run at least two experiments*. Then tack on 3 more months of runway so you can raise another round before you run out of money. This is the minimum amount of money you should raise. For example, let’s say you need $100K.

* Your experiments should be constructed such that a positive result will let you raise more money at a higher valuation.

2. How do we set a valuation from this budget?

Now decide what percentage of the company you will sell for $100K. Pick a number between 10% and 20% of the company’s post-money. You can go below 10% but that probably means your valuation will be too high or you will raise too little money.

For example, let’s say you’re willing to sell up to 15% of the company—that’s your bottom line dilution. This implies a bottom line post-money valuation of $666K.

3. How do we express our valuation to investors?

Finally, tell investors that,

“First, we think we can make the company significantly more valuable if we raise $100K—that’s our minimum. Second, we’re willing to sell up to 10% of the company.”

10% is your aspirational dilution. It’s the lowest dilution you can justify. It’s the lowest dilution you can say with a straight face.

Notice that you didn’t explicitly state your valuation. Combining the dilution (10%) with the minimum amount you’re raising ($100K) implies a minimum post-money valuation of $1M. But the valuation is not explicit. This gives you room to raise your valuation if you raise more than $100K (and we suggest you raise as much money as possible).

4. What’s the range for seed round valuations?

If $25K buys 1% of company, your post-money is $2.5M—that’s on the high end.

If $25K buys 5% of company, your post-money is $0.5M—that’s on the low end.

5. How low do seed round valuations go?

Y Combinator has set new lows for seed round valuations. They get away with it because they also set new highs for helping seed stage companies.

According to the YC FAQ, they buy about 6% of a company for $15K-$20K. So the post-money valuation of their investments is $250K-$333K.

But don’t fixate on valuation. Low valuations aren’t bad if you keep the dilution down too. 6% dilution is very low if the company makes a lot of progress with $15K-$20K.

6. How much money can we raise in a seed round?

If you sell 20% of your company at a $2.5M post-money, you raise $500K. That’s about the maximum for a seed round. Beyond that is Series A country.

7. How much dilution should we expect in a seed round?

Take as much money as you can while keeping dilution between 15-30% (10%-20% of the dilution goes to investors and 5%-10% goes to the option pool).

Compare this to a Series A which might have 30%-55% dilution. (20%-40% of the dilution goes to investors and 10%-15% goes to the option pool.)

A seed round can pay for itself if the quality of your investors and progress brings your eventual Series A dilution down from 55% to 30% (for the same amount of Series A cash).

Don’t over-optimize your dilution. Raising money is often harder than you expect, especially for first-time entrepreneurs.

Smart investors don’t over-optimize dilution either. They want to buy enough points to own a good chunk of the company. But they want to leave the founders with enough points to keep them highly motivated to build a lot of value for the founders and investors alike.

Finally, if you’ve made it this far, please enjoy the following presentation:

The questions and discussion were great. We had to stop early due to technical difficulties. Next time, we will do it via Skypecast which I hope will be flawless. We will post the time, date, and link for the next meeting soon. Please submit any ideas for office hours in the comments.

Finally, here are some edited highlights of the discussion. Please excuse any bad grammar, these are rough notes.

Control

Entrepreneur: We have an offer of $1M for 51% of the company. What do you think?

Venture Hacks: I wouldn’t take the 51% deal. At that point it is no longer your company. You are an employee. And you are no longer doing a startup. And you killed the entrepreneurial drive.

Investors who would like to buy 51% of your company don’t know how to invest. Especially if it is early stage. They think they are buying an asset that someone is going to run for them. But what they have done is killed the entrepreneurial drive.

Reject that deal out of hand. I would rather go back to eating Ramen noodles and working out of my parent’s basement. It is equivalent to selling your company for a little bit of money and going to work for your investors. Continue looking for another deal.

Don’t even talk to these 51% guys if they come back with a better offer. They have already made their intent to own 51% of the company clear.

Valuation

We want to raise $1M for 20% of the company or raise $2.5M for 30%-40%. How do we do it?

I don’t know what your company is worth. That is driven by the market. There is no right or wrong valuation. It is driven by your team, product, market, salesmanship, etc.

If you’ve hit 10 investors who make it a habit to invest and you haven’t gotten good responses and you can’t get a term sheet or verbal terms, you aren’t likely to get a term sheet if you talk to 20 more people. There is probably something wrong with the company and you should take a look in the mirror.

The #1 reason people are not able to raise money at the valuation they want is because the team is incomplete or does not appear up to the task. And that is tough feedback for a prospective investor to give. And if it isn’t the team, it is the product or traction.

How do I get a market clearing price?

You cannot clear the market in series. You have to do it in parallel. Set up 10 meetings to all happen in the same week. Some of them will flake out and you will end up meeting with 4-6 of them. Tell them all that you plan to sign a term sheet in 6 weeks and if don’t have an offer by that time, we are going to go back to the drawing board and using sweat equity to build the company.

You have to create that time limit.

If you go to market, go to market. The only way to get a market clearing price is to talk to a lot of people at once. I often see people go down the path with one or two investors. That is a mistake. Focus on the fund raising and get it done or go back and fix what is wrong with the company.

Don’t use the word “auction” with your investors but you need to run an auction. An auction is a double win for you. First, you focus your fund raising on a short period of time so you can get back to your customers. Second, it creates a positive feedback loop of scarcity and social proof. Those are the things that close deals.

Check out a book called Influence. Scarcity means “Hurry up or the deal is going to disappear.” Social proof means “Other people want to invest, don’t you?” Investors tend to move in herds that are steered by scarcity and social proof: “Sequoia is investing? I’m in.”

Dead Equity

If one founder has a (non-patented) idea and doesn’t add much value beyond the idea and the other founder does all the work, how do you split the founder’s equity?

It ranges from 1% – 10% of the founder’s equity. If someone has the idea, follow the Einstein maxim that “Genius is 1% inspiration and 99% perspiration” and give them 1% of the equity. If someone is active and helps you get started and has industry connections and stays active over time, you can give them closer to 10%.

Ideas are a dime a dozen. There are more good ideas than time. Ideas constantly change and you almost never end up doing what you started doing.

50-50 splits are unstable and the company falls apart. 2 years after the founding, one guy is still in the garage and says “Oh my God I’ve put in all this work, the idea has changed 5 times, and this other guy who is doing nothing has 50% of the company.” It is dead equity.

The percentages we are talking about here are the split between the founders.

Angels

I probably need $.5M to get my company off the ground. How do I set my terms with angels so it doesn’t screw me up down the road?

First, don’t give a huge discount if you expect to raise your Series A soon after the seed round. VCs don’t want to pay a big markup between the seed and the Series A unless time has passed (say 6 months) and traction has occurred. Typical discounts are between 20%-40%. Put time and traction between your financings.

Second, if you raise equity from angels they will probably have to approve the Series A. If you have a nasty angel, a “fallen” angel, who is trying to make money on just this one deal and doesn’t have a reputation to protect, he can try to hold you hostage on the Series A and veto your Series A until you give him some kind of good deal such as letting him put more money in at a good price. That’s a rare scenario but it does happen and the only way around it is to pick your angels carefully. If you raise debt, don’t give debt holders veto rights on the next financing.

Third, don’t give your angels perpetual warrants that don’t expire. If the company is a big hit, you don’t want your angel to come in right before the IPO and dilute everybody 10% at a very low cost. Avoid warrants in general, but if you do use them, set a short expiration.

A really clean debt agreement between you and experienced angels is the best way to get the company going. It leaves you with a ton of control. Check out Yokum Taku’s debt term sheet.

Approaching Investors

How do I approach VCs and angels?

You approach investors through people who know them. The best approach is through an entrepreneur whom they have backed and been successful with. Next best is probably someone who works with them such as an angel, or someone who sends deal to them, or someone who is associated with the industry. Third is probably your accountant or lawyer.

Fund-Raising Schedule

How do I time the fund raising?

In short, focus. Hit all the contacts at once. In your head, declare a start to the fund raising. Set up all your first meetings to happen in the first week.

If some investors are being slow while others are moving along, tell the slow people, “By the way, we are on second meetings with three funds.”

In a tight process, there are three meetings. One with the original guy you made contact with at the firm. Second, you meet the original guy and some of his partners. Third, there will be a partner’s meeting. There may be an intermediate session where some of them come to your office.